Meet John, a supermarket manager who is married with three school-age children and takes home a comfortable paycheck. Sure, he has some credit card debts and a couple of car loans, but he never misses a payment and assumes that getting a mortgage for a new home should be a piece of cake.
Then comes the bad news. After visiting several banks with a fat folder of financial documents, John is told he’s above the 43% Rule and his loan application is turned down.
What’s the 43% Rule?
The 43% rule is a ratio of debt-to-income, and a crucial standard for deciding who qualifies for a loan and who doesn’t.
In reviewing loan applications, lenders compute the ratio of a person’s debt relative to income. The standard for qualifying for a home loan is 43 percent for loans through the Federal Housing Authority and VA. Conventional home loans prefer the DTI be closer to 36% to insure you can afford the payments, but the truth is that qualifying standards vary from lender-to=lender. If monthly debt payments exceed 43 percent of calculated income, the person is unlikely to qualify, even if he or she pays all bills on time. At the urging of lenders, the Consumer Financial Protection Bureau asked Congress in early 2020 to remove the 43% standard as a qualifying factor in mortgage underwriting.
For other types of loans – debt consolidation loans, for example — a ratio needs to fall in a maximum range of 36 to 49 percent. Above that, qualifying for a loan is unlikely.
The debt-to-income ratio surprises many loan applicants who always thought of themselves as good money managers. Whether they want to buy a house, finance a car or consolidate debts, the ratio determines if they’ll be able to find a lender.
What Is a Debt-to-Income Ratio?
Debt-to-income ratio (DTI) is the amount of your total monthly debt payments divided by how much money you make a month. It allows lenders to determine the likelihood that you can afford to repay a loan.
For instance, if you pay $2,000 a month for a mortgage, $300 a month for an auto loan and $700 a month for your credit card balance, you have a total monthly debt of $3,000.
If your gross monthly income is $7,000, you divide that into the debt ($3,000 /$7,000), and your debt-to-income ratio is 42.8%.
Most lenders would like your debt-to-income ratio to be under 36%. However, you can receive a “qualified” mortgage (one that meets certain borrower and lender standards) with a debt-to-income ratio as high as 43%.
The ratio is best figured on a monthly basis. For example, if your monthly take-home pay is $2,000 and you pay $400 per month in debt payment for loans and credit cards, your debt-to-income ratio is 20 percent ($400 divided by $2,000 = .20).
Put another way, the ratio is a percentage of your income that is pre-promised to debt payments. If your ratio is 40%, that means you have pre-promised 40% of your future income to pay debts.
What Is a Good Debt-to-Income Ratio?
There is not a one-size-fits-all answer when it comes to what constitutes a healthy debt-to-income ratio. Rather, it depends on a multitude of factors, including your lifestyle, goals, income level, job stability, and tolerance for financial risk.
But there are general rules of thumb to follow when determining whether your ratio is good or bad:
- DTI from zero to 35%: Lenders consider this range a reflection of healthy finances and ability to repay debt. Wells Fargo, for instance, classifies a ratio of 35% or lower as representing a “manageable” debt level relative to your income, where you “most likely have money left over for saving or spending after you’ve paid your bills.”
- DTI from 36% to 43%: While you may still be managing your debt adequately, you are at increased risk of coming up short should your financial situation change. To use a health analogy, while your debt level may not rank as obese, you could benefit from some better financial-fitness habits. You still may be able to qualify for most loans, including mortgages, but you have little room for error. For that reason alone, you should look for opportunities to get your debt-to-income ratio in better shape.
- DTI from 44% to 50%: While you may still qualify for smaller loans, you will have a hard time landing a mortgage once your debt-to-income ratio exceeds 43%, though there have been recent efforts to relax that standard. If you’re in this category, now is the time to consider enrolling in a debt management plan or other debt relief program to improve your ratio and increase your credit-worthiness.
- DTI over 50%: This is generally regarded as an unhealthy level of debt for most households and should serve as a red flag to start working on reducing your debt burden ASAP. At this ratio, you will have trouble qualifying for most loans and are at risk of financial crisis should your expenses rise or income drop. If your debt-to-income ratio is over 50%, you’d be well-advised to explore credit counseling and/or consolidating debt payments.
Calculate Your Debt-to-Income Ratio in 4 Easy Steps
So the trick for many would-be-borrowers is a budget before they go shopping for a loan. Lowering a debt-to-income ratio can be the difference between a dream fulfilled and rejection. Calculating your debt-to-income ratio in easy 4 steps:
- Add up what you owe, including credit card debt, rent or mortgage payments, car loans, student loans, and anything else that you are expected to make a constant monthly payment on.*
- Then calculate your income: wages, dividends and freelance income, alimony, etc. **
- Now, convert each one of those to a monthly figure. If your annual income is $60,000, the monthly total is $5,000. Do the same for debt. If your annual debt total is $30,000, the monthly total is $2,500.
- Now divide your debt by your income and multiply by 100 to arrive at a percentage representing your debt-to-income ratio. In this example, that would be 30,000 divided by 60,000 = .5 x 100 = 50%.
Monthly Debt Payments That Are Included in the DTI Formula:
- Monthly credit card payments (you can use the minimum payment when calculating your DTI ratio)
- Monthly mortgage payment (including insurance, taxes, HOA payments)
- Monthly car payment
- Monthly student loan payments
- Monthly personal loan payments
- Monthly debt consolidation loan payments
Income Included in Your Monthly Income When Calculating DTI
- Income from wages, salary
- Income from tips, if applicable
- Income from self-employment (make sure it is verifiable via tax return)
- Income from alimony
- Income from child support
- Income from Social Security
- Income from a pension
- Disability income
- Income from investments such as rental properties, stock dividends and bond interest (must be documented on tax returns)
Monthly Payments Not Included in the Debt-to-Income Formula
Many recurring monthly bills should not be included in calculating your debt-to-income ratio because they represent fees for services and not accrued debt. These typically include routine household expenses such as:
- Monthly utilities, including garbage, electricity, gas and water services
- Paid television (cable, satellite, streaming) and internet services
- Car insurance
- Health insurance and other medical bills
- Cell phone services
- Groceries/food or entertainment costs
- Childcare costs
Front End and Back End Ratios
Lenders often divide the information that comprises a debt-to-income ratio into separate categories called front-end ratio and back-end ratio, before making a final decision on whether to extend a mortgage loan.
The front-end ratio only considers debt directly related to a mortgage payment. It is calculated by adding the mortgage payment, homeowner’s insurance, real estate taxes and homeowners association fees (if applicable) and dividing that by the monthly income.
For example: If monthly mortgage payment, insurance, taxes and fees equals $2,000 and monthly income equals $6,000, the front-end ratio would be 30% (2,000 divided by 6,000).
Lenders would like to see the front-end ratio of 28% or less for conventional loans and 31% or less for Federal Housing Association (FHA) loans. The higher the percentage, the more risk the lender is taking, and the more likely a higher-interest rate would be applied, if the loan were granted.
Back-end ratios are the same thing as debt-to-income ratio, meaning they include all debt related to mortgage payment, plus ongoing monthly debts such as credit cards, auto loans, student loans, child support payments, etc.
Why Debt-to-Income Ratio Matters
While there is no law establishing a definitive debt-to-income ratio that requires lenders to make a loan, there are some accepted standards, especially as it regards federal home loans.
For example, if you qualify for a VA loan, Department of Veteran Affairs guidelines suggest a maximum 41% debt-to-income ratio. FHA loans will allow for a ratio of 43%. It is possible to get a VA or FHA loan with a higher ratio, but only when there are compensating factors.
The ratio needed for conventional loans varies, depending on the lending institution. Most banks rely on the 43% figure for debt-to-income, but it could be as high as 50%, depending on factors like income and credit card debt. Larger lenders, with large assets, are more likely to accept consumers with a high income-to-debt ratio, but only if they have a personal relationship with the customer or believe there is enough income to cover all debts.
Remember, evidence shows that the higher the ratio, the more likely the borrower is going to have problems paying.
Is My Debt-to-Income Ratio Too High?
The lower your debt-to-income ratio, the better your financial condition. You’re probably doing OK if your debt-to-income ratio is lower than 36%. Though each situation is different, a ratio of 40% or higher may be a sign of a credit crisis. As your debt payments decrease over time, you will spend less of your take-home pay on interest, freeing up money for other budget priorities, including savings.